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Understanding the Economic Loss Rule

Timothy R. Hughes, Esq.
Hughes & Associates, P.L.L.C.

A recent opinion issued by Supreme Court of Virginia emphasizes the need for construction firms to understand the economic loss rule. The application of this doctrine depends on your particular state. The doctrine could have a significant impact on your liability exposure. Additionally, the doctrine could affect your ability to pass liability downstream to suppliers and manufacturers.

Contracts and Torts

First, we need to discuss the differences between the law of "torts" and the law of "contracts." Contracts deal with bargained expectations of the parties. Where one party fails to perform its obligations under the contract, the other party suffers disappointed economic expectations under the contract. Many states find that these types of damages are "economic losses" whose remedy is in contract, not tort.

In contrast, the law of torts deals with legally imposed duties. For example, we all have a duty imposed by law to drive reasonably. Where we fail to exercise reasonable and ordinary care driving and it leads to an accident, we may be liable for negligence. The claim for personal injuries arising out of the accident would sound in tort rather than contract.

It must be noted that the distinction between tort and contract has been deeply eroded in some states. Other states, such as Virginia, tend to strictly adhere to this distinction. The result is that some states present excellent possibilities for defenses to claims based on the specific facts of a case and that state's applicable law.

The Economic Loss Rule

The economic loss rule is very simple in concept. The economic loss rule provides that where a party sues for purely economic losses, the party that is suing needs to have a contract with the defendant. Some states, such as Virginia, strictly adhere to this rule. In Maryland, the doctrine generally holds true, but the Maryland courts do permit a party without a contract to bring suit for economic losses where the alleged breach presents an unreasonable risk of serious physical injury or death. Other states apply the concept with varying degrees of severity.

The complexity comes in the application. In states where the economic loss rule holds sway, plaintiffs continually attack application of the rule. For example, many states hold that professionals who commit malpractice may be sued in both tort and contract. If the suit is in tort against a professional, is a contract required? Some states require a contract. Other states permit a suit without a contract where the plaintiff could be reasonably expected by the professional to rely upon the professional's information. The ability to sue professionals without a contract has an obvious potential impact on construction projects where information is often provided by architects, civil engineers, geotechnical engineers, land surveyors and other licensed professionals.

Further complexity comes into the picture when one considers "property damage" claims. Claims for property damage are generally viewed as claims in tort rather than contract. In construction projects, however, people are usually fighting about the work of one subcontractor damaging the work of another. Virginia law would generally tend to view such claims as economic loss claims rather than property damages, but these types of issues can become very complicated depending on the facts of a specific case. The question of where economic loss begins and ends depends on the law of your particular state.

Case in Point —
EIFS, Pulte v. Parex

In a recent case, I represented a manufacturer of exterior insulation and finishing systems, also known as "EIFS" or synthetic stucco. Pulte Homes Corporation v. Parex, Inc. 256 Va.518, 579 S.E.2d 188 (2003). The EIFS product is an exterior cladding material. The plaintiffs' lawyers have argued that the product is defective because it is so impervious to moisture, that water leaking through adjacent elements of construction (such as leaking windows) gets trapped behind the EIFS leading to damage. The manufacturer's position is that its product works when properly applied and where the contractor uses proper coordination and design efforts for adjacent components.

In Pulte v. Parex, a homeowner purchased an EIFS clad home. The home had been built by Pulte and sold to the original owner who in turned sold the home to the plaintiffs. The plaintiffs alleged significant damages to their home and sued Parex, the EIFS manufacturer. The plaintiffs included a whole host of legal theories in their complaint (negligence, negligence per se, fraud, constructive fraud, violation of Virginia Consumer Protection Act, breach of implied warranty). Pulte in turn filed a cross-claim against Parex seeking recovery for breach of express warranty, breach of implied warranty, indemnification and contribution.

The trial court dismissed both the plaintiffs' and the homeowners' claims against the manufacturer. The court found that the manufacturer was remote to the transaction and that the plaintiffs failed to allege any specific representations from the manufacturer to the homeowner. The court also applied the economic loss rule and found there was no contract between the manufacturer and the homeowners. This ruling resulted in a dismissal of the negligence based claims and the breach of implied warranty claim. Finally, the court dismissed the cross-claim of the builder, again finding that the manufacturer was not in privity of contract with the builder. The court also found that there was no proper proof or allegations of the actual existence of an express warranty in the case.

On appeal, the Supreme Court of Virginia ruled that the trial court's decision dismissing the builder's claims was proper in all respects.

Some Practical Points

While you may be tempted to view the economic loss doctrine as legal "mumbo jumbo," I would suggest that you ignore this concept at your peril. First, the feast or famine environment of the construction industry naturally leads to individuals and companies going into bankruptcy. The net result could be that if you contract with a party who went bankrupt, you are left with no remedy even if you can prove a clear breach of contract.

Second, practical concerns may interfere. For example, you perform work for an owner who you want work from in the future. The owner's architect commits a serious error on the drawings, yet for business reasons you do not want to sue the owner because you want more work from them. Can you sue the architect directly and keep the owner out of the case? The answer depends on your state's law and its interpretation of the economic loss rule.

Similarly, you may have a specification for a specific type of brick or block that must meet certain performance standards. If the brick fails to meet the specification, you may want to pass that liability downstream. If your supplier is bankrupt, or if you want to avoid suing them for business reasons (such as they are the only reliable supplier in your area), you may have a tough time filing suit directly against the brick manufacturer.

Conclusion

As with my discussion of implied and contractual indemnification in my last column, I believe a prudent mason contractor needs to understand the law of its particular jurisdiction. This advice would extend to the question of the economic loss rule and its application. Knowing your state's law can only help you in establishing a fair price for the amount of risk you are undertaking. This knowledge can also help you evaluate how carefully you need to scrutinize the financial condition of your clients, subcontractors and suppliers. Without knowing or understanding the law of your jurisdiction before you enter into a contract, you could be left holding the bag.